How big banks cornered the tax-certificate market

Monday

Jul 30, 2012 at 12:01 AM

Property tax certificates for decades had provided a secure and profitable investment for individual investors and small businesses -- until the last couple of years, when the big banks, capitalized with cheap money from the federal government, shoved the small investor aside and came to dominate the business.

If you're not familiar with investing in tax certificates, here's a simple description of the process.

City, county, and state budgets are dependent on the collection of property taxes to fund day-to-day services, public-employee wages and long-term capital improvements. Without prompt payment of property taxes, municipalities would be forced to suspend or end services.

To ensure funding, when property owners are delinquent in tax payments, counties sell certificates of tax debt to investors. In Florida, the tax sales are annual, one-day events, all scheduled within a 30-day time frame. Investors agree to pay the taxes for a delinquent property owner by bidding an interest rate they will accept for repayment of the debt, and receive a certificate that is backed by a tax lien. Property owners that are delinquent in tax payments have up to two years to repay the debt plus interest. It's paid through the county. If the debt is not repaid within two years, the tax certificate investor can legally take ownership of the property, as the tax lien is paramount over all other types of liens, even mortgage notes.

It's a rare case when an investor is able to acquire the property, but it does happen, and sometimes the tax payment is pennies on the dollar compared with the property value. The vast majority of property owners or the banks that have a mortgage lien on the property repay the tax debt within the two years.

To protect the property owner, the county awards the certificate to the investor bidding the lowest interest rate, capped at a maximum of 18 percent APR. As with most investments, tax certificate investors generally determine what properties and interest rates to invest in by considering risk versus reward. Undeveloped scrub land, easement parcels or other low-value properties may not entice any investors unless the tax debt is minimal. Interest-rate bids on these properties are usually at the highest interest rate.

Conversely, homes and commercial properties are desirable to investors and provide the greatest security of repayment. These properties attract the largest number of bidders, and the competition drives down the winning interest rate. If there is more than one bidder at the same low interest rate, a lottery is held. This is the key to how the big banks have KO'd small investors from tax certificates.

Before 2009, interest return to investors on tax certificates ranged from 8 percent to 18 percent, and normally ranged higher than many other investments available to small individual investors.

A friend of mine is a retired business reporter who has paid for his retirement -- including a farm in Kentucky -- with his investments in tax certificates. It was always the domain of the small investor or group.

Not any more.

Infused with billions of taxpayer dollars at near zero interest rates, and with minimal returns on other secured investments, the big banks have found a profitable opportunity in tax certificates, and have cornered the market as something of a non-conspiratorial oligopoly in the last three years. They have opened large subsidiaries to invest in the property tax debt market.

The banks are willing to accept a far lower interest rate -- funded by taxpayer- generated loans -- than a small investor using his own capital is capable of doing.

One step the big banks have taken to destroy competition is to form thousands of subsidiary limited liability companies to pursue tax sales. As an example, Bank of America has a 400-plus-employee division specifically engaged in tax certificate auctions across the nation. The bank has also registered some 46,000 LLCs and LPs to acquire the certificates.

Why so many?

Most times, there are multiple bidders at the lowest interest rate, and the eventual winner is determined by a lottery drawing. What does this mean to a small investor who tries to compete?

Let's say there are 5,000 bidders at the lowest interest rate. The small guy has one chance to win, while the big banks have the other 4,999.

Sound fair to you?

Jack McCabe is chief executive officer of McCabe Research & Consulting LLC. He can be reached at jack@mccaberesearch.com.